Is Germany Catching Trump’s Tax Disease?

After months of negotiations, another grand coalition government – comprising Chancellor Angela Merkel’s Christian Democratic Union (CDU) and a grudging Social Democratic Party (SPD) – is taking shape in Germany. But the new government seems likely to miss the opportunity afforded by Germany’s strong economic and financial situation to pursue much-needed reforms.

In fact, the fiscal policies that Germany’s emerging government is discussing bear a remarkable resemblance to those of US President Donald Trump, whose tax plan, most economists agree, will bring limited short-term benefits to a few, but huge long-term costs to many more. Indeed, the incipient German government is discussing cutting taxes for corporations and the rich, while raising spending on public consumption, especially public pensions.

In the United States, Trump has convinced many of his lower-income supporters that his tax plan will benefit them, not just his wealthy cohorts. A similar feat has been accomplished in Germany, with some powerful lobby groups persuading middle-class voters that they will benefit from a tax cut.

These groups claim, for example, that raising the income threshold for the top marginal tax rate will help middle-income voters, even though the top marginal tax rate is now levied on just 7% of German employees. Similarly, the plan to abolish the tax surcharge on higher incomes (Solidaritätszuschlag), introduced after reunification in the early 1990s, would benefit almost exclusively the top 30% of earners.

This is all the more problematic because the top 30% of earners in Germany are already subject to a lower tax rate than 20 years ago, even though their wealth has increased. The bottom 70% largely pay much more in direct and indirect taxes, despite often having lower incomes.

The arguments for cutting corporate taxes are similarly flawed. Like Trump, German politicians and lobby groups claim that domestic firms need a tax cut in order to stay competitive internationally. Yet Germany’s export companies are undeniably very competitive, and have largely managed to increase their global market share since the 1990s. Moreover, corporate profits have reached record highs in recent years, and while corporate taxes in Germany remain relatively high compared to other countries, they were reduced significantly in the 2000s.

Beyond having only limited economic benefits, the proposed tax cuts in Germany – like Trump’s in the US – represent a huge strain on public finances in the long run. While Germany’s public sector currently boasts a surplus of about 1.3% of GDP, that is largely the result of good luck, not good policy: without low interest rates and a strong labor market, the federal budget would be in deficit.

Yet demographic shifts mean that contingent liabilities for public pensions and health care in Germany will rise sharply over the next decades. Covering these costs will require taxes to be increased substantially and/or for spending to be reduced – precisely the opposite of what the CDU/SPD government is promising.

This does not mean that Germany’s government should not contemplate any tax reductions or spending increases. But, in order to ensure that such changes have the maximum positive impact, without hurting younger generations, they must be designed fundamentally differently.

Arguably, Germany’s biggest economic weakness today is low private investment. With the German corporate sector having run up massive profits for more than a decade, the resources are certainly available. Yet overregulation, heavy bureaucratic burdens, policy uncertainty, poor digital and transport infrastructure, and, in some industries, a lack of skilled workers, are currently impeding investment by companies in new and existing capacity.

The government need not address all obstacles to investment and innovation at once. At the very least, it should create tax incentives for research and development, as well as for equity investments. It should also design provisions to support small and medium-size enterprises, while fighting tax evasion among big firms.

Moreover, Germany’s government should use its fiscal space to invest in education, in particular in pre-schools and primary schools. And it should invest in developing an internationally competitive digital infrastructure and a social security system that ensures labor-force participation and lowers long-term unemployment.

In many ways, Germany’s economy is thriving. But that is no reason for the government to waste its sizable fiscal surplus on economically useless tax cuts and spending increases. On the contrary, the surplus creates an important opportunity to tackle the long-run challenges that Germany faces – an opportunity that Merkel’s next government must not waste.